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Small states again

January 31, 2011

Port Vila, Vanuatu

Like supermodels, small island developing states are lovely but expensive. They’re usually isolated, so shipping costs are high. They tend to be hit frequently by natural disasters like cyclones and flooding. Because small countries are often so fragmented, domestic transport is exorbitant.

Often, international agencies with a free-market mindset make the mistake of blaming these high costs on the dead hand of government. Shrink the state, they say, and you will unleash an army of entrepreneurs. Competitive pressures will force down prices.

But many of the costs are inbuilt. However much you try to promote entrepreneurship or stoke competition, you can’t physically tow small islands closer to major markets. Science hasn’t yet figured out how to divert tropical cyclones or to compress an archipelago into a single land mass.

Smallness and fragmentation mean it’s difficult to achieve economies of scale. Kiribati, an expanse of atolls scattered across the international dateline, is the size of the Caribbean. Each atoll is only a few miles long, and only one, Tarawa, has more than a few thousand people. If the ocean surrounding French Polynesia were converted into land area, it would be the world’s 10th-largest country. Tuvalu is small-fry in comparison. It only takes up about a million square kilometres (but it looks nice). These countries are so spread out, and internal transport so expensive, that it is almost impossible to build up a producer or consumer base big enough to allow marginal costs to fall.

High prices make it difficult to produce anything that is competitive on world markets. When the costs associated with exporting a container from Vanuatu are US$1500 compared with about US$850 in New Zealand, it’s no surprise that most Pacific island states are strangers to the trade surplus. Agricultural exports in the Pacific have a dismal modern record. Fiji and Papua New Guinea are among the few economies to export much – mostly sugar and fish – and  only because of trade preferences. Costs can be so elevated that many private sector activities are totally unviable: outside Suva and Port Moresby, there aren’t many manufacturing plants in the Pacific region.

A paper by British economist Alan Winters on the cost of doing business in small island developing states concludes that even if workers did their job for free, many businesses would still receive negative returns. That means they’d effectively be paying the customer to receive their product. Winters concludes that “comparative advantage is not enough”.

Because the private sector is hampered by prohibitive costs, it’s so small that the state has to take up the slack. Commercial businesses simply wouldn’t provide some of  the services currently offered by government, and many developing island economies are so tiny that competition is a pipe dream. The government must stay involved in a range of areas – at least health, finance, education, even retail. And the state has to perform a backstopping role for almost all businesses in case they get into difficulty.

Tuvalu is typical. Paying for patients on dialysis machines abroad accounts for a large part of the health budget. Healthcare is far too small for privatisation, and the hospital hasn’t got the know-how or facilities for a machine of its own. Government simply must spend a large chunk of its budget on keeping people alive.

Across the Pacific, national banks and development banks tend to be the main sources of credit. When even the US financial system is dysfunctional, it’s hard to see how an economy with a GDP the size of David Beckham’s weekly pay packet is supposed to offer efficient and competitive private finance. As most business people can tell you, the foreign banks charge interest rates that would make a loan shark blush.

In small populations, the fixed costs of running a school for a tiny number of pupils are too high for it to be commercially viable. Private schools not only exclude the poor, but standards are difficult to enforce unless government takes direct ownership. Vanuatu has recently removed fees, with the state for the first time offering free primary education.

Even private retailers in many remote islands need the state to step in when supplies dry up. In Christmas Island at the end of last year, shops were getting so bare that people were starting to talk of reverting to their traditional diet of coconuts and fish. The Ministry of Commerce planned to charter a ship to bring in supplies.

The other problem with the free market view is that it fails to see that most small island developing economies are woefully inflexible. Even if it were a good idea to slash government spending, you simply can’t quickly lay off a large number of government workers because there are a limited number of industries for them to move into and because capital and know-how are in short supply. As part of the Cook Islands government reform programme in 1998, a large number of government workers were sacked. Most simply moved to Auckland.

This isn’t to say that the private sector can’t ever succeed. It can, as shown by the many thriving small businesses across the region – but only in certain areas. Neither is it to suggest that some government spending couldn’t be reprioritised or that governments couldn’t do their jobs better. They should probably provide things that complement the private sector, and where markets don’t do a proper job, like infrastructure, credit, health and education.

But shrinking the state, the stock response of free-marketeers, often simply creates gaps in the economy and exposes people to unnecessary risks. Like it or not, government has a prominent long-term role. As with Naomi Campbell’s liking for diamonds, small developing islands will stay in love with the state for a while yet.

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  1. Emergent Economics

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